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Many people consider money market mutual funds a stodgy investment. It is the place where conservative money resides. Yet regulators have voiced concern about their safety after some of these funds experienced difficulties during the financial crisis. This is in spite of a long history of operating without problems under normal economic conditions.

Are money market mutual funds as resilient as cash? Is a money market mutual fund as safe as a bank account? This paper examines money market mutual funds, reviews their role in our capital markets, and discusses what’s next for them.

What are Money Market Mutual Funds?

When consumers borrow, often the loan is long-term—a home mortgage, car loan, or student loan. Businesses do two types of borrowing: long-term to build a factory or develop the next big thing, and short-term to meet payroll and keep their day-to-day operations humming. Why are short-term loans necessary? Take John Deere. The company has to pay its workers to make tractors, but it can be a while before the tractors are sold and John Deere collects payment. So companies use short-term borrowing to cover temporary revenue shortfalls, for stretches as short as one day and as long as several months, and they do it constantly.

And it’s not just businesses that face uneven receipts and expenditures, governments do too. Uncle Sam, states, and local governments use short-term credit to ensure they can keep the lights on, pay employees, and provide services like picking up the trash. This is especially important for municipalities.

This is where money market mutual funds (MMFs) come in. An MMF is a specific type of mutual fund that is only allowed to invest in short-term investments. By providing short-term funds at affordable rates, MMFs make it cheaper and easier for businesses and governments to get the credit they need.

How are MMFs different than other mutual funds?

Like a typical mutual fund, the sponsor of an MMF pools the savings of investors into a fund typically organized as a trust. But MMFs are restricted in the type of investments they may make and they calculate their assets and liabilities in a way that is distinct from other mutual funds. And unlike other mutual funds, MMF investors can redeem their shares on demand at the price they paid for them. In that sense, they share some similarities with bank accounts, in addition to the ability to write checks on some accounts.

A typical mutual fund invests people’s savings in a wide variety of stocks, bonds, and other securities, each designed to meet investor needs and risk appetites. The mutual fund issues shares to investors representing their individual slice of the assets in the trust. Mutual funds have a variety of investment strategies, and their performance is typically tracked against a benchmark—such as the S&P 500—to allow investors to measure how well their mutual fund is doing against the broader market.

But unlike a typical mutual fund, an MMF is restricted under the Investment Company Act of 1940 to only investing in short-term, high quality securities. This means that the fund holdings must mature within a much narrower time period than other mutual funds.* The securities held must have a high credit rating and offer minimal credit risk.1

* An MMF must be able to receive its total principal and interest payments within a maximum of 397 days, and most investments have much shorter time horizons.

There are Two Main Types of MMFs:

Government Funds – These funds invest solely in government securities, such as Treasuries and securities issued by federal agencies and quasi-governmental federal agencies (Fannie Mae and Freddie Mac). MMFs are also the primary source of short-term lending to state and municipal governments, holding 75% of this type of debt.2

Prime – These funds invest in private sector obligations, as well as government debt, and carry more risk of default compared to government funds. Corporations like John Deere issue commercial paper—basically an IOU—to obtain interim funding, and MMFs buy this debt as an investment. MMFs hold 37% of the commercial paper outstanding, making them an important source of funding for corporations.3 MMFs also invest in short-term obligations such as certificates of deposit and repurchase agreements—which like commercial paper are short-term loans to high-quality companies, but unlike commercial paper they are backed by collateral.

MMFs provide benefits for all types of investors. They are widely used by both institutional and retail investors to help manage the cash they have on hand. They can be used by investors as a place to put their money while looking for other investment opportunities or to ensure that they will have easy access to their funds for other purposes, such as making a down payment for a home or buying a car.4 In addition, MMFs offer investors a cost-effective way to diversify their investments in short-term credit markets.5

How Are MMFs and Money Market Deposit Accounts Different?

While these two types of products sound the same, they aren’t. Money Market Deposit Accounts (a.k.a. bank savings accounts) are offered by banks as a savings vehicle. They fall under commercial banking regulation and are not an investment product. There are limits on Money Market Deposit Accounts, like minimum balances and limits on withdrawals, and unlike MMFs, they are insured by the Federal Deposit Insurance Corporation (FDIC).6

The NAV, the Floating NAV, and the Shadow NAV

As noted earlier, one difference between a typical mutual fund and an MMF is the type of assets in which they can invest. The second difference is the way MMFs report their value to investors. That brings us to something called the “NAV,” “the floating NAV,” and the “shadow NAV.”

NAV stands for “Net Asset Value,” and it is defined by the SEC as a mutual fund’s total assets minus its total liabilities.7 If an MMF holds $50 million in assets and has $10 million in liabilities, its NAV is $40 million. To determine the NAV per share of an MMF, you divide the NAV by the number of shares outstanding. If an MMF has a $40 million NAV and 40 million shares outstanding, it has a $1 per share NAV.

All mutual funds calculate their NAV every business day. Most mutual funds use mark-to-market accounting, which means mutual funds calculate the value of the assets in their portfolio based on their market value at the close of each day. Because the value of the mutual fund’s assets and liabilities changes daily, the NAV changes daily—that is known as a “floating NAV.” Mutual funds publish their floating NAV every business day, and investors can redeem their shares at the floating NAV.8

What makes an MMF unique is that its NAV does not float, it stays stable. MMFs maintain a $1 per share NAV daily, which is known as a $1 stable NAV. Because MMFs are restricted to investments in short-term, high quality assets, fluctuations in their NAV are typically tiny. Therefore, MMFs are allowed to use amortized cost accounting—which means they can value their securities at the price they bought them instead of using mark-to-market accounting, as long as these securities have less than 60 days to maturity.9

OK—MMFs publish a $1 stable NAV daily, but we just noted that fluctuations in their NAVs occur. What’s happening here?

Although MMFs use amortized cost accounting, if they instead used mark-to-market accounting their NAV would fluctuate, or float, just like a traditional mutual fund. It usually fluctuates a tiny amount—maybe $1.001 or $0.999 per share. The tracking of these fluctuations is called the “shadow NAV.” MMFs do not publish their shadow NAV for investors every day, but are required to report their shadow NAV to the Securities and Exchange Commission (SEC) every month. The SEC publishes the shadow NAV 60 days later.10

But what happens when an MMFs shadow NAV experiences an unusual drop in value?

When the shadow NAV drops below $0.995 per share (i.e. one half penny below a dollar per share), MMFs may no longer use amortized cost accounting to maintain a $1 stable NAV. They are forced to switch to a floating NAV, publishing this value every day for investors.

Likewise, if the assets of an MMF are greater than its liabilities such that the shadow NAV is greater than $1.005, MMFs pay dividends to their shareholders to get the shadow NAV closer to $1 per share.11

What is Breaking the Buck?

In its most simple explanation, it is the switch from a $1 stable NAV to a floating NAV. Historically, when the shadow NAV of an MMF has approached $0.995 per share, the financial institution that created the fund has contributed additional money to keep their assets above $0.995 per share so they can continue to publish a $1 stable NAV.12 But on rare occasions, the management of the fund has been unable to do this.

On one such occurrence, in August 2008, the commercial paper offered by Lehman Brothers qualified under SEC rules as a liquid, short-term investment for MMFs. Yet on September 15, 2008, Lehman Brothers filed for bankruptcy. Virtually overnight, this liquid, short-term investment dropped precipitously in value. Investors in Lehman paper were left holding the bag.

One such investor was the Reserve Primary Fund—the oldest and one of the largest MMFs in the United States. The $62 billion Reserve Primary Fund held $785 million of Lehman commercial paper, and losses on these assets dropped its shadow NAV to $0.97 per share.13 Three cents per share may not seem like a whole lot of money, but in the MMF world it is very significant.

In the case of the Reserve Primary Fund, in the midst of the financial crisis, the sponsor was unable to kick in cash to maintain the $1 stable NAV. The fund was forced to “break the buck” and go to a floating NAV.14

The Reserve Primary Fund was the first MMF open to the public to break the buck, and the second one ever.* Its failure to maintain a $1 stable NAV sparked a panic in the market, leading investors to withdraw their money from other prime MMFs for fear they held Lehman debt or the debt of other troubled companies. Since MMFs are not insured, people began to pull their money from these funds to avoid potential losses. In the period immediately following Lehman’s bankruptcy, institutional investors redeemed $300 billion from many prime MMFs.15 However, many government MMFs—viewed to be safer than prime funds—saw significant inflows from investors over this same period.16

* The only other MMF to break the buck was the Community Bankers U.S. Government Fund in 1994.

Why did the Reserve Primary Fund “breaking the buck” cause such volatility in the market?

As former SEC Chairman Mary Schapiro explained, regulators worry that by maintaining a $1 stable NAV, MMFs “have been given a false sense of security."17 In other words, regulators believe that in 2008 investors did not understand that their MMF was made up of securities that fluctuate in value and can lose money.

It is the ability of MMF investors to redeem their shares at a stable $1 per share—i.e. to get all of their money back on demand—that gives MMFs their similarity to bank accounts (in addition to the ability to write checks on some accounts). The fear is that they are seen to be as secure as cash. However, investments in MMFs are not like deposits at an FDIC-insured bank. Like commercial banks that pool the savings of depositors and loan them out, MMFs don’t leave the money they collect lying around, they invest in short-term assets. Though these investments rarely lose money, they can. And unlike commercial banks, which are protected by FDIC insurance to remove the incentive for depositors to quickly remove their cash, MMFs do not have a government guarantee.

Like depositors racing to get their money out of a troubled bank before the cash on hand is gone, if MMF investors think the assets of their fund will lose value, they could rush to redeem their shares at the $1 stable NAV before the MMF breaks the buck and they lose money. There is a shared risk among investors, in that the outcome for any one investor may rely on the actions of others. No one wants to be left with losses, which can lead to some MMF investors heading for the exits all at once in times of market stress.

The withdrawals from MMFs during the crisis looked a lot like a run on commercial banks. Without a regulatory backstop to encourage investors to keep money in MMFs, the government intervened by offering a blanket guarantee against losses.18 In the absence of such a guarantee, regulators were concerned that significantly more money would have been quickly withdrawn from prime MMFs to avoid potential losses—freezing credit markets and leaving businesses and households with less access to short-term cash.

When market participants speak of markets “seizing up” this is one of the nightmare scenarios they discuss. Without these credit markets operating fully, businesses and governments struggle to get short-term loans. Without short-term loans, payrolls cannot be met. When payrolls cannot be met, the economy stops. This is what regulators mean when they say that MMFs pose systemic risk in times of crisis, despite their safety under most economic conditions.

MMFs After the Financial Crisis

2010 MMF reforms

In 2010, the SEC adopted a number of regulatory changes to address shortfalls exposed by the financial crisis. While MMFs faced many investment restrictions pre-crisis, these reforms were designed to make MMFs even more transparent and resilient in times of economic stress. The changes included increased diversification requirements and enhanced maturity limitations—steps to strengthen the safety of MMFs.

In addition, the 2010 regulations mandated new liquidity requirements, limits on the types of securities that can be held, increased disclosure and reporting requirements, and new stress tests. This will help regulators and investors keep a closer eye on MMF investments.19

What is the scope of additional MMF reforms?

Despite these reforms, regulators believe that MMFs still pose risk to the financial system. The Financial Stability and Oversight Council (FSOC) was created by the Dodd-Frank Act to protect against systemic risks—hazards that could cause vast damage to financial markets and the overall economy. In November 2012, FSOC identified MMFs as a potential source of systemic risk, and released recommendations to reform MMFs for public comment.

Proposals for reform can be broken down into three general categories: 1) requiring MMFs to switch to a floating NAV, 2) maintaining the $1 stable NAV with redemption restrictions, and 3) maintaining the $1 stable NAV with required capital buffers.

Floating NAV – Regulators are concerned that a $1 stable NAV encourages investors in MMFs to think that their shares are risk-free—that they can never lose money. Regulators believe a floating NAV would make investors more aware of the fluctuating value of their investment—no matter how small the fluctuations—making MMFs less likely to experience a run in times of market stress. They point out that the fact that MMFs can lose money would be made more explicit.The Investment Company Institute, a trade group representing the mutual fund industry, argues that a floating NAV is impractical for MMFs.20 There are many institutional investors—such as pension funds—that rely on the stability of current MMF valuations. The tax and legal ramifications would be significant. If MMFs were to use floating NAVs, it is argued that many customers would flee these products, shrinking the industry while leaving less capital for business. Walt Bettinger, the President and CEO of Charles Schwab, has suggested a hybrid option by allowing a floating NAV for the riskier prime MMFs that invest in commercial assets, while maintaining a $1 stable NAV for MMFs that invest in government assets.21

Redemption Restrictions – Another option would be to limit the ability of MMF customers to get all of their money back by redeeming their shares on demand. Regulators point out it is this ability that makes MMFs susceptible to runs. Funds that lock-in investor money for a specific period of time do not face such stark liquidity risks.The problem is that the immediate redemption that MMFs offer is one of their most attractive features for investors. Limits on redemptions would likely reduce the attractiveness of these funds.

Capital Buffers – If MMFs are going to maintain a $1 stable NAV, some regulators want them to hold capital buffers—funds that can absorb losses on assets that are held in a portfolio— to maintain liquidity in times of market stress. As FSOC states in its report, “because [MMFs] lack any explicit capacity to absorb losses in their portfolio holdings without depressing the market-based value of their shares, even a small threat to an MMF can start a run."22 Supporters argue that maintaining capital buffers would give MMFs more capacity to maintain a $1 stable NAV during times of market stress.The issue, of course, is how much capital MMFs should be required to hold as a cushion. Regulators have tossed around capital buffers of 3% or 5% of assets; industry proponents are concerned that a capital buffer would make these vehicles unprofitable, thereby killing the industry.23

What’s Next for MMF Reform?

On June 5, 2013, the SEC offered a new proposal with two alternatives to reform MMFs with a 90 day public comment period. One proposal would require prime MMFs to use a floating NAV and the other would permit MMFs to limit immediate redemptions in times of financial stress.24 SEC Chairman Mary Jo White recently commented that the agency would aim to preserve the economic benefits of MMFs while addressing their susceptibility to runs that could hurt investors.25

Laurence Fink, the CEO of the world’s largest asset manager BlackRock, argued in The Wall Street Journal that opposition to reform does not instill confidence in the markets.26 Creative solutions should be explored, he argues. Regulators and policymakers should think through the consequences of any changes to MMFs— including the accounting and tax ramifications—to ensure that short-term credit markets are not disrupted and investors don’t unnecessarily lose a valuable product.

Conclusion

MMFs provide valuable short-term funding to governments and businesses and offer investors a flexible investment vehicle. Yet the financial crisis showed that they can be susceptible to “bank runs” in times of extreme financial stress, without the same regulatory structure in place that mitigates the dangers of commercial bank runs.

Regulators, such as FSOC and the SEC, have been taking a closer look at MMFs and what role this product plays in the financial system. Policymakers have a responsibility to build a resilient financial system that protects investors and taxpayers. They should closely monitor regulatory developments regarding MMFs to ensure that these funds do not pose dangers to the financial system.

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